Jeff Dean and Gerry Black have been trading as a team for many years and have evolved along with their approach to trading options. The two launched the ITB Capital Management commodity pool in 2006 largely as a naked option writing strategy. It slowly has become more of a volatility value strategy that both buys and sells options on the S&P 500.
“Like most options sellers, we like volatility. It is just getting there, the rate of change of the volatility, that is what caused problems,” Dean says.
That rate of change caused some large drawdowns in the early days of the program, particularly in 2008, so the two added long option positions to hedge the risk of volatility spikes.
“When we are buying options it is 1) for risk management and 2) to capture incremental return based on where we perceive the movement is going to be over the next options cycle,” Dean says.
In addition to being both buyers and sellers of options, ITB looks at both technicals and fundamentals and uses discretion.
“Jeff and I are never off the desk, we are consistently moving positions,” Black says. “Most [option] sellers I’ve run into are very static, they sell both sides and wait. We are actively running it by the minute. If the risk-reward does not show that it is wise to keep that short position, we are going to move it or we are going to take a long position to counteract it.”
Black was introduced to Dean in the 1980s through another customer of the stock and futures brokerage James I. Black & Co., which his father launched in 1964. Black began to trade futures for himself and select customers. “I realized that Jeff and I traded very similarly. We very rarely disagreed on anything,” Black says. “When we decided to do the fund, I asked Jeff if he would retire from his [executive position at a building product firm] and go out on a venture with nothing. He said, ‘Yes,’ and we did it.”
While the program had immediate success both in terms of performance and building assets, it returned double-digits in each of its first two years and surpassed $50 million under management in six months. ITB had its best year in 2012, 30.5%, after making two significant changes.
After dropping more than 20% in July and August of 2011, ITB expanded its options buying.
“We [studied the drawdown] over and over to see what went wrong,” Dean says. “We figured out that we were lifting our [option buying] techniques too quickly and weren’t adjusting the short positions correctly, so we refined our program. It really turned out that we were taking a little upside off of the table.”
Most trades are now initiated as ratio spreads, but they can leg into butterflies as well and constantly adjust positions initiated at the beginning of each monthly option cycle.
“We found that by reducing our risk exposure a [little], we could decrease our overall risk a lot,” Black says. The new approach evened out their returns and even allowed them to earn profits in dangerously volatile months for pure option writers.
“We didn’t have any 6% to 7% months; however, we didn’t have any down months [in 2012]. There were a couple [of] months that we might have had a loss, but with our long positions we ended up making 0.5% or 1%,” Black says.
“Most of our profit comes from collecting premium,” Dean adds. “The long side is overlaid for risk management and incremental [profit]; some months it might be quite a substantial portion of our profit.”
The other change involved ITB reporting returns based on the monthly option expiration cycle instead of the calendar month.
“We were finding that between options expiration day and the end of that calendar period, we were making trades to protect our profits for the month,” Black says. “If we had a good month going into expiration and volatility picked up between expiration and the end of the month, we found that we were making short-sided trades only looking out to the end of the month to protect profits or reduce losses.”
Those trades hurt the program, increased the program’s trading frequency and, subsequently, its costs.
ITB has decreased its trade frequency by 50% since moving to the option expiration cycle. The reporting change also dampens the volatility of the program by allowing it to not be subject to frequent erroneous settlement prices, according to Black.
The changes produced the best performance in the seven-year history of ITB, which now manages $170 million in three pools and a managed account program, which all trade in a similar fashion.
“We are not trying to hit home runs every month; we are just trying to make a decent profit,” Dean says. “We just dialed down the program somewhat; part of that has been through less aggressive selling and a little more aggressive buying to hedge risk.”